Fed rate hikes won't bring down inflation as long as government spending stays high, paper says

cnbc.com:

Federal Reserve Chairman Jerome Powell proclaimed Friday that the central bank has an «unconditional» responsibility for inflation and expressed confidence that it will «get the job done.»

But a paper released at the same Jackson Hole, Wyoming summit where Powell spoke suggests that the Fed can't do the job itself and actually could make matters worse with aggressive interest rate increases.

In the current case, inflation is being driven largely by fiscal spending in response to the Covid crisis, and simply raising interest rates won't be enough to bring it back down, researchers Francesco Bianchi of Johns Hopkins University and Leonardo Melosi of the Chicago Fed wrote in a white paper released Saturday morning.

«The recent fiscal interventions in response to the Covid pandemic have altered the private sector's beliefs about the fiscal framework, accelerating the recovery, but also determining an increase in fiscal inflation,» the authors said. «This increase in inflation could not have been averted by simply tightening monetary policy.»

The Fed, then, can bring down inflation «only when public debt can be successfully stabilized by credible future fiscal plans,» they added. The paper suggests that without constraints in fiscal spending, rate hikes will make the cost of debt more expensive and drive inflation expectations higher.

In his closely watched Jackson Hole speech, Powell said the three key tenets informing his current views are that the Fed is primarily responsible for stable prices, public expectations are critical, and the central bank can not relent from the path it has drawn to lower prices.

Bianchi and Melosi argue that a commitment from the Fed simply isn't enough, though they do agree on the expectations